Who is to blame for bloated CEO pay? Your favored answer to that question will tend to reflect your prior beliefs, which is why high pay is now being blamed on index funds. That’s a stretch, but the fact is that investors in the stock market, broadly, are more part of the problem than they might like to admit.
When it comes to investing in the stock market, there are two broad churches. There’s active management: pay clever people to identify the stocks that are going to go up, and buy those stocks. Then there’s passive management: just buy a basket of stocks, encompassing pretty much everything that is for sale, and rise and fall with the tides of the market as a whole. Passive management is very cheap—you sometimes pay as little as 30 cents per year for every $1,000 invested. Active management, on the other hand, is generally expensive: An active manager like David Winters, of the $300 million Wintergreen Fund, charges a total of $24.70 per year for every $1,000 invested. For long-term investors, fees of that magnitude really add up and can easily wipe out all of the manager’s real gains.
Believers in the Passive Church generally stop there. Their way results in higher returns over the long term, case closed. And in the case of David Winters, they’re entirely correct. While the S&P 500 has gone up by 126 percent over the past 10 years, the Wintergreen Fund has risen just 37.7 percent. Essentially, investors have paid 50 times as much in fees in return for 30 percent of the performance.
Believers in the Active Church, by contrast, like to broaden out the argument. To be sure, they still think that returns are important, and active managers try to outperform some passive benchmark, ideally after fees. But they also love to come up with other reasons why it’s a good idea to avoid passive investing, and Winters, in his most recent annual report, has a doozy. The 2.47 percent that Wintergreen charges, writes Winters in his annual letter, is in fact 39 percent cheaper than 4.3 percent, which he says is “the average management fee advertised by the leading S&P 500 index funds.”
Even Winters’ most devout followers could be permitted a raised eyebrow at this claim, since, obviously, passive S&P 500 index funds don’t charge anything near a 4.3 percent management fee. Indeed, their actual management fee is normally about one-hundredth of that amount.
So what is Winters talking about? It turns out that his 4.3 percent number is basically the amount of stock that S&P 500 companies issue to their employees every year, as part of their various stock-based compensation plans. Winters seems to think that if it weren’t for passive investors voting for corporate compensation plans, that number would come down to zero, and that investors in those passive plans are therefore losing out, somehow, on that extra 4.3 percent. It’s not a fee, exactly, but it’s a cost, maybe? That ultimately shareholders shoulder. And Winters explicitly blames passive investors for the existence of that cost, as a part of his argument for why active investing is better.
This logic was recently dismantled, quite elegantly, by Jason Zweig in the Wall Street Journal. Passive investors don’t vote in favor of corporate compensation plans much more often than active investors do, and in any case the newly issued stock is, simply, an amount that corporate employees are paid for doing their jobs. Most investors, including most investors in the Active Church, like the idea of paying employees in stock, since it aligns incentives. It’s therefore more than a bit weird that Winters seemingly thinks that employees up to and including the CEO should receive no stock at all and indeed that they should not even receive any cash in lieu of the stock they’re currently getting. After all, if they did continue to receive stock, or if they received cash in lieu of stock, then shareholders would still be paying that 4.3 percent that he’s so worried about.
Still, Winters does have a kernel of important insight, which is that shareholders shouldn’t be in favor of higher executive pay. The more money that is extracted from a business by its CEO and other senior executives, the less there is left over for shareholders. And that’s an insight that seems to be lacking on the other side of the debate.
Take James Rowley, an investment strategist at passive-investing giant Vanguard. Rowley was also quoted in Zweig’s story, arguing against Winters’ assessment by saying that “Active fund managers want one stock to do better relative to others. We want all our underlying portfolio companies to compete against each other to do better.” Vanguard nearly always votes in favor of stock-based executive compensation schemes, and Rowley paints that as being in investors’ best interests. If higher executive pay made companies less efficient, he’s saying, then that would make them less competitive. He says that he doesn’t want that: He would prefer that the companies he invests in were more competitive, not less.
The problem is that what Rowley said is not true. Competition is good for consumers, who get lower prices, but it’s bad for investors, who see slimmer profit margins. The larger those margins, the more money the companies are making for their shareholders, and the better their stock tends to perform. When companies compete against each other, by contrast, they force each other to lower their margins, their profits, and, ultimately, their share prices. That’s why unregulated monopolies like Facebook make so much money and have such valuable shares.
There’s an increasingly popular theory that as passive investment rises and as even active investors diversify their holdings within an industry (the airline industry, say), the people who ultimately control the companies—their shareholders—don’t want them to compete with each other. Instead, they want the companies to collude with each other, if only implicitly, to keep prices and profits high for everyone. And this isn’t just a theory. There’s some evidence that it’s happening and might be part of the reason why the stock market as a whole is so richly valued these days.
The world we’re currently living in is one where companies make money by raising prices, as opposed to one where they’re constantly trying to undercut their competitors. The resulting corporate culture, which has been hugely profitable for stock-market investors as a whole, has thereby become a bit more padded, a bit more comfortable. Big-company CEOs now make more than $15 million a year, on average, most of it in stock; their C-suite colleagues also take home millions.
Winters is being a bit silly when he sees top-level executive compensation as a tax on shareholders. The average S&P 500 company has a market capitalization of $47 billion and earnings of $2.1 billion; if you cut CEO pay by $15 million, that would make no visible difference to either number. Winters is also wrong to blame passive investors for executive pay: Active investors are just as much to blame. But he’s right that shareholders generally are presiding over a stock market made up of companies that pay themselves handsomely and consider that to be a perfectly normal and justifiable cost of doing business.
The problem with CEO pay is not that it’s unfair to shareholders. It’s that it’s just unfair, period. And if there’s a problem with passive investing, the victims are, similarly, not the people holding the index funds. Rather, it’s everybody else—the 50 percent of the population that owns no stock at all but who still have to pay to consume the products that the corporate world manufactures.
Fund managers like Winters think of shareholders as the little guy, the “mom and pop investors” who are being harmed, somehow, by the actions of the passive-investing giants. But the truth is that those giants—Blackrock and Vanguard—have been great for mom and pop investors. Much better, indeed, than fund managers like Winters, who has done well neither for consumers nor for investors. The big point that both the Passive Church and the Active Church are missing is that both of them have ended up harming everyday Americans who don’t own stocks at all. As the two churches snipe at each other in the pages of the Wall Street Journal, it’s worth sparing a thought for the majority of Americans—people who live paycheck to paycheck and, quite rightly, go nowhere near the stock market. They’ve been the big losers in the recovery of the past 10 years, and there’s no sign that they’re going to catch up anytime soon.